Tuesday, January 26, 2016

Fed giving government bonds as collateral

Ramanan picked off a good one the other day in this moron-fest we continue to observe, probably somehow why the bonds have rallied:


André said...

I don't understand what is wrong. The Fed does give bonds as collateral for reverse repos...

Ryan Harris said...

I don't understand the hilariousness either. The largest users of the facility have been foreign central banks, and foreign central banks sometimes need short term access to US-Ts to also post as collateral. It reduces the number of FTDs in the market. If they can loan money to the central bank and get US-Ts overnight and the central bank prevents rates from falling as everyone scrambles for US-Ts, where is the problem?

Ramanan said...


If I borrow from a bank for a house, the house is a collateral which the bank may take away from me if I default.

But why would the Fed give US Treasuries as collateral. Suppose there is a highly unlikely event that the Fed defaults and doesn't pay back reserves to foreign central banks. What would foreign central banks do with the US Treasury?

Coming back to me borrowing from a bank. Can I give a bond issued by me as collateral? What would the bank do if I default?

snowball1205 said...

I don’t think this is correct. It used to be correct and selling Treasuries was the way the Fed drained reserves from the banking system. When banks have excess reserves they wanted to get a return by lending them to other banks. This tended to drive the overnight rate to zero, preventing the Fed from hitting its interest rate target, But that all changes in October 2008, when the Fed began paying interest on excess reserves. Si, it was no longer necessary to drain reserves or sell treasuries (other than it was law).

Ramanan said...


It's not so perfect.

I think the Fed cannot pay interest to foreign central banks on reserves.

So if the Fed doesn't do reverse repos, foreign central banks may lend below 0.25% which the Fed doesn't want.

So it has to do reverse repos ... which is more or less the same thing as paying interest.

Ryan Harris said...

Obviously the Fed defaulting is preposterous and the risk is very close to zero. I don't think the collateral is about risk of default by the Fed, but about setting rates. There is imperfect transmission of short term rates to the real economy unless the Fed can impact treasury rates, mortgage rates, money market rates and corporate bond rates. Setting short term treasury rates by increasing the supply is one good way to prevent the shortages and rate problems we've seen in the past where real rates dip below fed rates during month end. If we look at the RRP results, there are large spikes in usage around month end. Which sort of confirms that the policy sets a floor in rates by providing supply and preventing shortage but not really to address credit risks.

Regulation and credit market growth in middle of last century prevents banks from interacting with most consumers, business and finance as they otherwise would, so the Fed has to try novel approaches to overcome the idiocy otherwise the FFR has essentially become irrelevant as a policy tool. Directly borrowing money from non-regulated dealers isn't allowed. And old fashioned OMOs are basically non-existent, at least in the way we tend to describe rate setting tools in the stodgy old world of "modern" monetary econ. So the contorted RRPs are used, I'd think since it really isn't about quantity of reserves but supply of regulatory collateral.

Modern monetary theory is a euphemism like "Modern" used in interior design to describe the way things looked during a part of last century. We need better econ that really describes how and why credit flows in the real world now.

Ramanan said...


So what exactly is it about collateral?

The foreign central banks can use it for other things? Why does the Fed worry about it?

Does the Fed's objective state this? It is primarily about setting interest rates. Surely collateral has its dynamics but that's a different thing. It can simply do it without posting Treasuries as collateral.

Matt Franko said...

"the policy sets a floor in rates by providing supply and preventing shortage but not really to address credit risks."

Well then why dont they just start to let the portfolio run off?

TIP: they (at least) think they need the munnie from the interest on the portfolio otherwise they could go (to them) bankrupted...

André said...


One thing is to criticize central bank operations. We know that they don't make sense in a modern fiat money system. And we know that most people in this world (incluiding central bankers, commercial bankers and politicians) are not aware of that.

Other thing is to use a diferent dictionary from the rest of the world. The bonds in the repo operations are collateral, and are legally regocnized as so. These bonds are legally binding. The fact that the operations are badly designed doesn't change the legal characterisation of the ownership and rights in the repo bond collateral.

"Coming back to me borrowing from a bank. Can I give a bond issued by me as collateral? What would the bank do if I default?"

Of course I can. No bank would accept it, but I could do it, and the bond would be collateral. The bank would be stupid to accept it, but that doesn't change the fact that my bond is a collateral. If I defauted, the bank could try to sell my collateral, but it would probably be worthless. The bank could also call for legal proctection to recover his claims on the loan and/or the collateral.

Rewriting the dictionary is not a good way to critcize. It just enables communication problems.

Ramanan said...


Fair point about legal issues. A foreign central bank could sue the US government but it's not clear what it could do if the Fed itself were to default. I would imagine holding a deposit at the Fed has little about default in legal agreements.

But my point would be ... if it comes to the Fed indeed defaulting ... such as due to political reasons ... the creditor would have an equally difficult time with or without collateral.

Where am I rewriting the dictionary. I just find it funny that the US government is giving its own bonds as collateral.

André said...

Oh, sorry. I read it wrong. I thought you were suggesting that the bonds are not actually collaterals.

In that case, feel free to make fun of people who accept it hehe. Actually banks don't have a choice, they must follow Fed rules and accept it... But that's odd indeed...

Tom Hickey said...

I think it might be fairly simple. Central banks are banks and they are run by bankers. Bankers operate based on "best practices" aka standard operating procedure, which doesn't distinguish among different types of monetary system. Collateral is just part of banking. Bank lending is about liquifying collateral.

Banks earn a profit by the spread between the avg. rate they charge and the avg. rate they pay. The difference between central banks and commercial banks is that the former set the rate independently while the latter have to set rates competitively. I doubt that most bankers even realize that central banks are monopolists in this regard since they view CBs as reactive rather than proactive, so that markets are actually determining rates. I suspect that most central bankers look at central banking through the lens of banking in general.

From our POV it looks daft, but from theirs this is just what bankers do for a living. They would think it crazy not to do this "the way it has always been done."